The Ukraine crisis and energy politics

Events in Ukraine are unlikely to prompt severe energy shocks, though the risks are growing.

The crisis in Ukraine has triggered the worst East-West tensions since the end of the Cold War. Following a de facto Russian invasion, Crimea voted by referendum on March 16th to secede from Ukraine and join Russia; the EU and the US imposed sanctions the following day. The measures are nonetheless modest, targeting with travel bans and asset freezes a few dozen officials from Russia and Ukraine. Sanctions announced to date fail to hit top personnel at Russian energy companies and in themselves have few economic implications.

Yet the deteriorating situation raises concerns about supply and price shocks in oil and natural gas markets. Since sanctions were imposed, Russia has recognised the Crimean vote, signed a treaty confirming the annexation of Crimea and promised to respond in tit-for-tat fashion to Western measures—more of which could be imposed this week. Energy companies and energy users worry about the possible impacts. How concerned should they be?

Assessing the short-term risks

As we argued in the early days of the crisis, both sides have much to lose if matters spiral out of control. The EU depends on Russia for roughly 30% of its gas, around one-half of which flows across Ukraine through the Brotherhood pipeline owned by Russia’s gas-export monopoly, Gazprom. Memories of stoppages on this pipeline amid pricing disputes in 2006 and 2009 doubtless exacerbated a spike in gas prices as the crisis in Ukraine flared up (albeit from low levels; they have since subsided). Economic recovery in Europe remains tentative, giving Russia greater leverage over EU policymakers.

However, Russia’s energy relationship with the EU is a double-edged-sword. Oil and gas revenues contribute around one-half of Russia’s national budget, and most of its gas exports go to the EU—70% in 2012, according the BP Statistical Review of World Energy 2013. (Russia is trying to re-orient its gas sales towards Asia, but this is a long-term undertaking.) More broadly Russia’s economy, which shows "clear signs of a crisis" in the words of a Russian minister this week, depends disproportionately on its larger neighbour.

This interdependence means neither crippling sanctions nor a shooting war is on the cards, we believe, and the crisis is likely to be managed to an acceptable stand-off. A prolonged shut-down of the Brotherhood or other pipelines risks sparking a more general trade war with the EU and is clearly against Russia’s interests. In our view, a shut-down targeting the EU, on the heels of other retaliatory measures, is therefore unlikely.

Another low-probability scenario involves a stoppage on the Brotherhood link precipitated by a failure on the part of economically troubled Ukraine to pay its approximately US$1.5bn in gas arrears. Compounding matters, Russia has cancelled a discount on gas exports granted to Ukraine’s now ousted president, Viktor Yanukovych. Still, even if Russia suspended gas sales to Ukraine, thus cutting supplies to the EU along the Brotherhood pipeline, the implications for Europe would be less dramatic than they would have been in the past. The bloc depends on Russia to satisfy a smaller proportion of its gas demand than used to be the case; for its part, Russia has more options to move gas westwards, using routes bypassing Ukraine and currently running below full capacity. EU gas-storage levels are anyway high after a mild winter, while consumption of the fuel has lagged in recent years owing to weak economic conditions.

Should supplies nevertheless run short, Europe’s price-sensitive electricity utilities are likely to turn in the first instance mainly to favourably priced coal. Indeed, an official German spokesman this week argued that his country could tap into its coal stockpile if necessary. Power companies preferring to make a like-for-like switch may be able to draw on additional sources of liquefied natural gas (LNG) due to enter the market this year from Australia and Papua New Guinea, though competition from Asia would be stiff. (This could push up LNG prices from around US$16/million British thermal units (mBtu) in 2013 to US$18-19mBtu or so.) In the case of a disruption to Russian oil exports, to pre-empt a price spike the US and EU member states are expected to resort to a release from their strategic reserves, and Saudi Arabia would be called upon to raise production.

A riskier scenario

For these reasons, we continue to believe that the short-term effects of the Ukraine crisis on energy markets will be limited. Balanced against this, though, the risks of a further deterioration of the situation are mounting, potentially prompting more serious impacts on energy markets.

The most deleterious of these would be an escalation of tensions in east Ukraine. Russia has massed troops on the border and is accused of orchestrating provocations that could provide a pretext for an invasion. In recent days Ukraine, which has generally exercised restraint in the face of larger Russian forces, has sent heavy military equipment to the region. Adding to concerns, it yesterday authorised troops in Crimea to fire in self-defence after the killing of a Ukrainian officer in the region. Ukraine’s government says the soldier was shot in a Russian attack on one of its military bases.

Should a full-blown war break out, energy prices would inevitably spike in response, even without taking account of the immediate implications of any supply interruptions. In addition, Western leaders are discussing further sanctions designed to punish future escalations: EU measures targeting officials at Gazprom and Russia’s state oil company, Rosneft, are reportedly on the table. These would spark reprisals from Russia, which threatens to freeze or seize foreign assets within its borders. Visa bans on US politicians are also rumoured.

Whether the EU has the resolve to punish Russia forcefully is dubious, however. While some countries are reportedly pushing for tighter sanctions, Italy and Germany—which import large quantities of Russian gas—are believed to be particularly concerned about taking aim at Russian energy officials. Many east European countries are far more reliant on Russian gas, measured as a proportion of their gas needs. This makes some (Slovakia, for instance) highly reluctant to antagonise Russia, though others (Poland, especially) are hawkish. The lack of political cohesion within the EU provides further reasons to doubt the magnitude of the impact the crisis will have in energy markets.

Long-term options

As events in Ukraine have unfolded, politicians and commentators have suggested various ways for Europe to replace Russian gas with supplies from other sources. Imports via the planned Southern Corridor route from the Caspian is one such option; shipping in North American shale gas in the form of LNG (registration required) might be another; others hype Europe’s potential to develop its own shale-gas resources. To the extent that these options bring the EU relief, however, it will not arrive for some years.

The Southern Corridor is not expected to make a difference until the end of the decade. Similarly, the infrastructure for exporting gas extracted from US or Canadian shale formations is a long way from reaching meaningful scale: the first shipments are not expected until early 2016. A better-supplied market would help Europe, and several major European utilities have signed contracts to purchase US gas from 2016-17. But North American shipments would be sold mainly to more lucrative Asian markets. The utility of shale gas as a political tool for the US is therefore muted.

Development of Europe’s own unconventional resources is an even more distant and uncertain prospect. We do not expect significant volumes of European shale gas to reach the market before 2020; they are anyway unlikely to make much of a dent in EU reliance on Russia, especially given Europe’s declining conventional-gas production. For the rest of this decade, then, EU dependence on Russian gas, and Russia’s dependence on European energy demand, are here to stay.